The forex options course pdf

The trader observing that the volatility was at an extreme would look to option strategies which benefit from a loss of volatility. One such strategy is the carry trade. Benefiting from a Loss of Volatility The carry trade is an option strategy that benefits from a loss of volatility. One month implied volatility for the yen versus the dollar fell to A decline in volatility encourages carry trades as it makes the profit more predictable.

Forex option traders should frequently scan the currency pairs comparing historical versus implied volatility. The key question to ask in reviewing historical versus implied volatility is: Which of these depicted currency pairs would you trade and in what direction? Write down your reasons. The high volatility of the USDCAD suggests that the prices are unusually high in the underlying, further suggesting a sell strategy.

Forecasting Volatility Changes While implied volatility is usually compared with historical volatility, it can also be com- pared with a projection of the volatility. A projection of volatility attempts to provide a leading indicator to the trader. There are many technical analysis firms trying to do this for institutions. For example, in Figure 2. This forecast was based on the use of implied volatility analysis. The idea behind this projection is that the data showed that the implied volatility associated with that strike price was much higher This was considered very extreme and therefore to have a high probability of returning to a lower volatility level.

Once the trader can find this kind of projection, many different option trading strategies can be for- mulated, including hedging, writing options, and the like. Of enormous importance to those trading forex options is the emergence of ETFs on cur- rencies. These provide a greater amount of analytical information than readily available at forex firms. Forex traders should track all of the key currency ETFs.

For example, Figure 2. This could be used as an indication to put on a long time spread—buy ATM call in January and sell ATM call in December , for example; comparing the slope of option volatility against a forecasted slope leads to further insights about which option strategies can fit market conditions. Here is what Myron Woods of ORATS, the options analysis firm, says about this: A high forecast slope relative to implied slope indicates that a vertical spread in- volving selling a lower strike option and buying an upper strike option looks at- tractive, from the perspective of relative valuation of the implied volatilities of the lower strike versus the upper strike.

In other words, the lower strikes i. The Volatility Cheapness Index The volatility cheapness index at Optima provides another useful way of spotting currencies that are in extreme modes of volatility. The volatility cheapness index measures how implied volatility currently compares to the last five years of history of volatility, ranked on a percentile scale ranging from zero lowest to highest. We can see in Table 2. The Swiss franc was ranked lower, at We will identify these strategies in Part Two, but generally speaking, if volatility is expected to increase, then the option trader will look to play range-probing or range- breaking price actions.

Volatility and Price Movement—Sigma Boundary Charts In order to visualize what volatility actually implies for future price movement, it is useful to view a one-standard-deviation projection of price movement out into the future. This is called a sigma boundary chart. In order to do this, we simply take the current level of implied volatility, which is an annualized figure, and reduce it to shorter time frames, projecting the sigma boundary cone ahead from the current date.

In a normal data dis- tribution, the price movement will typically remain within plus or minus one standard deviation about two-thirds of the time, within plus or minus two standard deviations 95 percent of the time, and within plus or minus three standard deviations 99 percent of the time. By projecting a one-standard-deviation sigma boundary cone looking ahead, we can get a visual picture of the boundaries for price movement that the market is expecting. Specifically, the options market in the implied volatility figure is forecasting a two-thirds chance that the price movement will remain within the one-standard-deviation boundary in the future.

If a trader believes that the price movement is actually likely to breakout of that enve- lope, then the trader essentially believes that volatility is cheap and the trader may want to buy volatility. By the same token, if the trader thinks the price movement will remain within the one-standard-deviation envelope, then the trader effectively thinks volatility is expensive and may want to sell volatility.

The trader need not try to calculate the standard deviation of volatilities. This is done for the trader by different analytical services. For example, Optima Investment Research generates standard deviation ranges for five currency futures pairs.

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This provides a use- ful source for linking volatility and price movement, and also for identifying resistance and support ranges since the market prices sometimes bounce off the one- and two- standard-deviation price levels see Table 2. Seeing this, the trader would look to 1.

There are several strategies. A range trading strategy reflecting this chart would suggest a sell of 1.

The sigma charts provide a unique and quick way of targeting option strike prices based on volatility. Spotting a Volatility Cone If a trader spots a volatility cone, then there is an opportunity to detect and conjecture which options are overpriced or undervalued.

In the volatility cone chart in Figure 2. Source: Optima Investment Research, www.

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This allows traders to trade volatility directly. The concepts of historical and implied volatility were reviewed. Important vi- sualizations of volatility are also available to the trader, and software presenting volatility surfaces and smiles become important elements of trading options on the currencies. To help the trader, many software services are now available that offer sophisticated ana- lytics on volatility. S It is a process resulting from an evaluation of market conditions.

The selection process is very much subjective. To be successful, it requires that the trader adopt a preferred direction where he or she has maximum confidence in the result. Gaining confidence about a direction of a forex option trade involves understanding several di- mensions, explained in detail in Chapter 3. In addition, you will find an introduction to the binary options on the FOMC decisions as well as instruction on using housing sector data for developing forex option direction decisions.

Of all of the factors moving currency prices, this is the most important and will be discussed in greater detail later in this book.

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The following column appearing in Bloomberg is a typical example of commentary throughout the year regarding interest rates and a currency direction. To make a decision on anticipated direction, the forex trader can use the interest rate expectation calculator found at www. DOWN 0. Technically, we mean the action the FOMC makes on the federal funds rate at its meetings.

These are the interest rates paid on loans made between banks also known as depository institutions. The Federal Reserve therefore uses the policy tool of increasing or decreasing these loan rates to achieve policy goals. A currency will strengthen if the market perceives that there is reason for interest rates to increase. The market forms an expectation about the next central bank deci- sion on interest rates.

This expectation then governs the sentiment between central bank meetings. So the first thing that a trader needs to do is to group the world of currencies into three groups: currencies with interest rates expected to go up, currencies with in- terest rates expected to go down, and currencies with interest rates expected to stay the same.

The forex trader must consider these correlations between interest rate ex- pectations and direction in shaping the duration of the trade. There are now very effective ways of anticipating FOMC decisions that we will demonstrate in the next section.

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How can the trader answer this question and go beyond just guessing? Answering this question is the focus of a great deal of work throughout the world. For the readers of this book how- ever, there is a very effective way and it is in fact supported by official Federal Reserve Bank analysis. This important tool should be understood by forex traders. The fed fund futures contract is cash settled to the simple average overnight fed funds rate for the delivery month see Figure 3. The basis for obtaining a strike price by the subtraction of the targeted rate — , allows for the market to bet not only on whether the FOMC will change rates but also on how incremental the change will be.

The options market can be used to estimate the probabilities associated with several possible paths for the target federal funds rate over the next several FOMC meetings. An important study concluded that options on federal funds futures provide a simple but powerful means for extracting market expectations for the possible outcomes of FOMC meetings. In other words, the forex trader who wants to trade the FOMC decision can use the federal funds option information to help identify the probabilities involved in an impending decision.

The trader has to be more quantitative about it. A bet- ter way to express it is that rates can go down or up in increments of 25 basis points www. So our focus here is on presenting the best direct tool for enabling the trader to get an informed opinion about what the FOMC will do and also actually trade the FOMC decision directly! The forex option trader is very fortunate because the federal funds contract has a revolutionary option on it—binary options traded on the CBOT. A good source for review for those who want to become familiar with binary options on the fed funds is www.

Here is how it works. There are only two payout possibilities. The up-to-date settlement values can be found at: www. The target is converted into an option strike price. So a target of 4. In other words, the trade gets strike prices that allow an anticipation of what the FOMC meeting will do.

The binary option is on the underlying federal funds rate directly. This contrasts with options on the average federal fund rate. The contracts also cover the next four meetings, so it provides a longer time frame as well. Also there is no other outcome. The trader either gets or gets 0. In a regular option purchase, the risk is limited to the premium paid, but the gain can vary.

Figure 3. We can see that the binary option limits the payout. A major advantage is that the binary option also limits the risk on writing the option. A trader can in effect play the house and write an option and have no further risk other than owing the difference between what the trader receives premium paid by the buyer and The strike prices are then subject to being bought or sold written. If the trader writes a call at a strike price of The buyer of the 96 strike price is paying a premium and betting that the rates will be — 96, or 4 percent.

The seller believes it will stay above that.